Why is the Shiller P/E flawed?

Today I would like to take a stab at the question “why is the Shiller P/E flawed?”

red recycling arrows with blue background and the text: why is the Shiller P/E flawed?

What is CAPE and why is the Shiller P/E flawed?

The cyclically adjusted P/E-ratio is calculated by taking the average over the past ten years’ inflation adjusted earnings.

This may sound as a good way of looking at the value of a company, but this way of looking at deep value is actually not the best way to go about. I will explain why it is not in this post.

First of all when you are calculating the Shiller P/E you are averaging over the previous ten years.

What that means is that one years’ calculation contains almost the same information as next year.

To illustrate what I mean consider this figure:

Schematic illustration of selecting two different ten year periods with just one year differing.

Figure 1. Schematic illustration of selecting two different ten year periods with just one year differing.

The first selection contains the same years as the second selection. Only one year changes.

So, in effect, you only have data points each tenth year and not each year as it is presented.

Looking backwards

The Shiller P/E is only a way of looking in the rear view mirror and not ahead.

As we all know a trailing P/E does not give you any information about coming earnings.

It does, however, give you an idea of past earnings.

If you want to make real money in the market you will have to guess future earnings which a Shiller P/E does not do.

Then ten years is a long time. We all know that.

During this time small-cap companies often change and sometimes even dramatically.

Their business model may change so to calculate an average over ten years makes no sense.

Moreover, the accounting methodology over the past ten years has changed which makes the Shiller P/E even more flawed.

What do you suggest instead?

Instead I propose to look at the inflation adjusted earnings of the past three years and using that as a guess for next year.

I believe this is a better metric because it gives the investor a clearer idea of what to expect for next year’s earnings.